Council of Economic Advisors

Testimony before the Joint Economic Committee, U.S. Congress
"The Economic Report of the President"

N. Gregory Mankiw
Chairman of the Council of Economic Advisers

Kristin J. Forbes
Member of the Council of Economic Advisers

Harvey S. Rosen
Member of the Council of Economic Advisers

February 10, 2004

Chairman Bennett, Ranking Member Stark, and members of the Committee,
thank you for the opportunity to discuss the release of the Economic
Report of the President and the current challenges facing economic
policy.
The Economic Report released today covers a wide range of issues,
including recent business cycle developments, tax policy, the health
system, regulation, and the role of the United States in the world
economy.

The U.S. economy made notable progress in 2003, propelled forward by
pro-growth policies that led to a marked strengthening of activity in the
second half of the year and put the United States on a path for higher
sustained output growth in the years to come.

The recovery was still tenuous coming into 2003, as continued fallout from
powerful contractionary forces.the capital overhang, corporate scandals,
and uncertainty about future economic and geopolitical conditions.was
offset by stimulus from expansionary monetary policy and the
Administration.s 2001 tax cut and 2002 fiscal package. The contractionary
forces dissipated over the course of 2003, and the expansionary forces
were augmented by the Jobs and Growth Tax Relief Reconciliation Act
(JGTRRA) that was signed into law at the end of May.

The economy appears to have moved into a full-fledged recovery, with real
gross domestic product (GDP) expanding 4.3 percent over the four quarters
of 2003, significantly above the average growth rate since 1960 of 3.3
percent. This growth was particular strong in the second half of the
year, after the passage of the Jobs and Growth tax relief bill. The last
two quarters of 2003 showed the most rapid growth of any half-year period
in nearly 20 years. The labor market is also starting to improve.
Payroll employment reached a trough in August, and the economy has since
created 366,000 jobs. The unemployment rate has fallen from a peak of 6.3
percent to 5.6 percent.

This Report discusses this turning of the macroeconomic tide,
along with
a number of other economic policy issues of continuing importance. The 14
chapters of this Report cover five broad topics: macroeconomic
policy,
fiscal policy, regulation, reforms of the health care and tort systems,
and issues in international trade and finance. In all of these areas, the
Report highlights how economics can inform the design of public
policy and
discusses Administration policies.

The Administration.s pro-growth tax policy, in concert with the dynamism
of the U.S. free-market economy, has laid the groundwork for sustainable
rapid growth in the years ahead. Well-timed fiscal stimulus combined with
expansionary monetary policy to offset and eventually reverse the
contractionary forces impacting the economy. But there is still much to be
done. The tax cuts must be made permanent to have their full beneficial
impact on the economy. A stronger economy will also result from progress
on the other aspects of the Administration.s economic agenda, including
making health care more affordable; reducing the burden of lawsuits on the
economy; ensuring an affordable and reliable energy supply; streamlining
regulations; and opening markets to international trade. These
initiatives are discussed in this Economic Report of the President.

MACROECONOMIC POLICY

Chapter 1, Lessons from the Recent Business Cycle,
discusses
the distinctive features of the recent recession and subsequent recovery,
and draws five key lessons for the future. The recent business cycle was
unusual in that it was characterized by especially weak business
investment but robust consumption and housing investment. This makes clear
the first lesson, that structural imbalances such as the .capital
overhang. that developed in the late 1990s can take some time to resolve.
A number of events contributed to a climate of uncertainty in 2003,
including the terrorist attacks of September 11, 2001, corporate
governance and accounting scandals, and geopolitical tensions surrounding
the war with Iraq. The second lesson from the recent business cycle is
that the effects of the uncertainty from these events on household and
business confidence can have important effects on asset prices, household
spending, and investment. Resolution of some of the uncertainties appears
to have contributed to the resurgence of growth.

Monetary and fiscal policies played a critical role in moving
the economy back toward potential. Third lesson is that aggressive
monetary policy can help make a recession shorter and milder. The fourth
lesson is that tax cuts can likewise boost economic activity. Tax cuts
raise after-tax income, while at the same time promoting long-term growth
by enhancing incentives to work, save, and invest. Tax relief enacted in
2001 and 2002 helped lessen the severity of the recession, while the 2003
tax cut appears to have propelled the economy forward into a strong
recovery. Job creation has lagged behind, even as demand has surged. Thus,
the fifth lesson of the recent recession is that strong productivity
growth, as was experienced in 2003, means that much faster economic growth
is needed to raise employment. This productivity growth, however, is not
to be lamented, since it ultimately leads to higher standards of living
for both workers and business owners.

Chapter 2, The Manufacturing Sector, examines recent developments
and
long-term trends in manufacturing and considers policy responses.
Manufacturing was affected by the economic slowdown earlier, longer, and
harder than other sectors of the economy and manufacturing employment
losses have only recently begun to abate. The severity of the recent
slowdown in manufacturing was largely due to prolonged weakness in
business investment and exports, both of which are heavily tied to
manufacturing.

Over the past several decades, the manufacturing sector has experienced
substantial output growth, even while manufacturing employment has
declined as a share of total employment. The manufacturing employment
decline over the past half-century primarily reflects striking gains in
productivity and increasing consumer demand for services compared to
manufactured goods. International trade has played a relatively small
role by comparison. Consumers and businesses generally benefit from the
lower prices made possible by increased manufacturing productivity, and
strong productivity growth has led to real compensation growth for
workers. While the shift of jobs from manufacturing to services has
caused dislocation, it has not resulted, on balance, in a shift from .good
jobs. to .bad jobs.. The best policy response to recent developments in
manufacturing is to focus on stimulating the overall economy and easing
restrictions that impede manufacturing growth. This Administration has
actively pursued such measures.

Chapter 3, The Year in Review and the Years Ahead, reviews
macroeconomic
developments in 2003 and discusses the Administration forecast for 2004
through 2009. Real GDP growth picked up appreciably in 2003, with growth
in consumer spending, residential investment, and, particularly, business
equipment and software investment increasing noticeably in the second half
of the year. The labor market began to rebound in the latter part of
2003. Inflation remained well in check, with core consumer inflation
declining by the end of the year to its lowest level in decades. The
improvement in the economy over the course of the year stemmed largely
from faster growth in household consumption, extraordinary gains in
residential investment, and a sharp acceleration of investment in
equipment and software by businesses. Payroll employment bottomed out in
August and rose 254,000 over the remainder of the year and a further
112,000 in January. Financial markets responded favorably to the
strengthening of the economy, with the total value of the stock market
rising more than $3 trillion, or 31 percent, over the course of 2003.

The Administration expects the economic recovery to strengthen further in
2004, with real GDP growth running well above its historical average and
the unemployment rate falling. Boosted by pro-growth policies and
expansionary monetary policy, and on the foundation of the underlying
strength of the free-market society in the United States, the economy is
expected to continue on a path of strong, sustainable growth.

FISCAL POLICY

Chapter 4, Tax Incidence: Who Bears the Tax Burden?, discusses the
analysis of how the burden of a tax is distributed among taxpayers. This
question is important to policy makers, who want to know whether the
distribution of the tax burden (between rich and poor, capital and labor,
consumers and producers, and so on) meets their criteria for fairness.
The key result is that the economic incidence of a tax may have little to
do with the legal specification of its incidence. Rather, it depends on
the actions of market participants in response to the imposition of the
tax.

Distributional tables showing the tax burdens borne by different income
groups are an important application of incidence analysis. When used
properly, distributional tables can contribute to informed decision making
on the part of citizens and policy makers. Unfortunately, mainstream
economic analysis suggests that these tables do not always accurately
describe who bears the burden of certain taxes. This problem does not
arise from bias or lack of economic knowledge on the part of the
economists who prepare these tables. Instead, it reflects resource and
data limitations, uncertainty about some of the economic effects of taxes,
and variations in the time frame considered by the analyses.
Nevertheless, the shortcomings of distributional tables can lead to
misperceptions of the impact of tax changes.

An important implication of the economic analysis of incidence is that, in
the long run, a large part of the burden of capital taxes is likely to be
shifted to workers through a reduction in wages. Analyses that fail to
recognize this shift can be misleading, suggesting that lower income
groups bear an unrealistically small share of the burden of such taxes and
an unrealistically small share of the gain when capital income taxes are
lowered.

Chapter 5, Dynamic Revenue and Budget Estimation, examines how
taxes
affect the behavior of firms, workers, and investors and discusses the
implications for the estimated effects of a tax change on revenue.
Changes in taxes and spending generally alter incentives for work,
investment, and other productive activity.a higher tax on an activity
tends to discourage that activity. Revenue estimation is called dynamic
if it incorporates the behavioral responses to tax changes and static if
it does not incorporate these behavioral responses.

To make informed decisions about a policy change, policy makers should be
aware of all aspects of its budgetary implications. Currently, official
revenue estimates of proposed tax changes incorporate the revenue effects
of many microeconomic behavioral responses. However, these estimates are
not fully dynamic because they exclude the effects of macroeconomic
behavioral responses. Several obstacles have prevented macroeconomic
behavioral responses from being incorporated in such estimates. This
chapter discusses the ongoing efforts to provide a greater role for fully
dynamic revenue and budget estimation in the analysis of major tax and
spending proposals. At least in the near term, it may not be practical
for macroeconomic effects to be incorporated in official estimates. But
estimates of these effects should be provided as supplementary information
for major tax and spending proposals. Dynamic estimation of policy
changes should distinguish aggregate demand effects from aggregate supply
effects, include long-run effects, apply to spending as well as tax
changes, reflect the differing effects of various policy changes, account
for the need to finance policy changes, and use a variety of models.

Reform of entitlement programs remains the most pressing fiscal policy
issue confronting the Nation. Chapter 6, Restoring Solvency to Social
Security, examines the largest entitlement program. Social Security is
a
pay-as-you-go system in which payroll taxes on the wages of current
workers finance the benefits being paid to current retirees. While the
program is running a small surplus at present, deficits are projected to
appear in 15 years; by 2080, the Social Security deficit is projected to
exceed 2.3 percent of GDP. These deficits are driven by two demographic
shifts that have been underway for several decades: people are having
fewer children and are living longer. The President has called for new
initiatives to modernize Social Security to contain costs, expand choice,
and make the program secure and financially viable for future generations
of Americans.

This chapter assesses the need to strengthen Social Security
in light of its long-term financial outlook. The most straightforward way
to characterize the financial imbalance in entitlement programs such as
Social Security is by considering their long-term annual deficits. Even
after the baby-boom generation.s effect is no longer felt, Social Security
is projected to incur annual deficits greater than 50 percent of payroll
tax revenues. These deficits are so large that they require a meaningful
change to Social Security in future years. Reform should include
moderation of the growth of benefits that are unfunded and would otherwise
require higher taxes in the future. However, the benefits promised to
those in or near retirement should be maintained in full. A new system of
personal retirement accounts should be established to help pay future
benefits. The economic rationale for undertaking this reform in an era of
budget deficits is as compelling as it was in an era of budget surpluses.

REGULATION

Chapter 7, Government Regulation in a Free-Market Society,
discusses
the
role of the free market in providing for prosperity in the United States
and considers situations in which government interventions such as
regulations would be beneficial. An important reason for Americans' high
standard of living is that they rely primarily on markets to allocate
resources. The government enables the system to work by enforcing
property rights and contracts. Typically, free markets allocate resources
to their highest-valued uses, avoid waste, prevent shortages, and foster
innovation. By providing a legal foundation for transactions, the
government makes the market system reliable: it gives people certainty
about what they can trade and keep, and it allows people to establish
terms of trade that will be honored by both sellers and buyers. The
absence of any one of these elements.competition, enforceable property
rights, or an ability to form mutually advantageous contracts.can result
in inefficiency and lower living standards. In some cases, government
intervention in a market, for example through regulation, can create gains
for society by remedying shortcomings in the market.s operation. Poorly
designed or unnecessary regulations, however, can actually create new
problems or make society worse off by damaging the elements of the market
system that do work.

Chapter 8, Regulating Energy Markets, discusses
economic
issues relevant to several energy markets, including natural gas,
gasoline, electricity, and crude oil. While energy markets generally
function well, some parts of the energy industry have characteristics
associated with market failures. These could stem from the large fixed
costs required to construct distribution networks for electricity and
natural gas that give rise to market power in the form of a natural
monopoly. Alternatively, the market may not function well in the presence
of negative externalities, such as when energy producers and
consumers do
not fully take into account the fact that burning fossil fuels may cause
acid rain or smog.

Minimizing disruptions is an important consideration in the design of
regulations to address shortcomings in energy markets. Federal, state,
and local regulations can have conflicting goals. If the conflicting
goals are not balanced, competing regulations could lead to worse problems
than the market failures the regulations attempt to address. Moreover,
regulations need to be updated as markets evolve over time to ensure that
their original goals still apply and that these regulations are still the
lowest-cost means of meeting those goals.

The chapter also examines global trade in energy products. The United
States benefits from international trade in energy products because
meeting all U.S. energy needs from domestic sources would require
significant and costly changes to the U.S. economy, including changes in
the types of transportation fuels used by Americans. But this leads to
the possibility of occasional supply disruptions. An important
consideration is that the price of oil is set in global markets, so that
disruptions to the supply of oil from areas that do not supply the United
States affect domestic prices of oil even if U.S. imports are not directly
affected. Fortunately, changes in the U.S. economy over the past three
decades and the increasing sophistication of financial markets have
diminished the impact of supply disruptions and temporary price changes on
the United States.

Finally, the chapter considers the role for government in subsidizing
research and development into new energy sources. In general, policy
makers should avoid forcing commercialization of new energy sources before
market signals indicate that a shift is required. One potential problem
with forcing this process is that technological breakthroughs may lead to
alternatives in the future that are hard to imagine today. Premature
adoption of new technologies would raise energy costs before the need
arises, causing society as a whole to spend more on energy than needed.

Chapter 9, Protecting the Environment, discusses market-oriented
approaches to safeguarding and improving the environment. While the
free-market system typically promotes efficiency and economic growth, the
absence of property rights for environmental .goods. such as clean air and
water can lead to negative externalities that reduce societal well-being.
This problem can be addressed by establishing and enforcing property
rights that will lead the interested parties to negotiate mutually
beneficial outcomes in a market setting. If such negotiations are
expensive, however, the government can design regulations that consider
both the benefits of reducing the environmental externality as well as the
costs of the regulations.

Regulations should be designed to achieve environmental goals at the
lowest possible cost, promoting both environmental protection and
continued economic growth. Indeed, economic growth can lead to increased
demand for environmental improvements and provide the resources that make
it possible to address environmental problems. Some policies aimed at
improving the environment can entail substantial economic costs.
Misguided policies might actually achieve less environmental progress than
alternative policies for the same cost. Environmental risks should be
evaluated using sound scientific methods to avoid possible distortions of
regulatory priorities. Market-based regulations, such as the
cap-and-trade programs promoted by the Administration to reduce common air
pollutants, can achieve environmental goals at lower cost than inflexible
command-and-control regulations.

REFORMS OF HEALTH CARE AND THE LEGAL SYSTEM

Chapter 10, Health Care and Insurance, discusses the
roles of
innovation, insurance, and reform in the health care market. U.S. markets
provide incentives to develop innovative health care products and services
that benefit both Americans and the global community. The breadth and
pace of innovation in the provision of health care in the United States
over the past few decades have been astounding. New treatment options,
however, have also been associated with higher costs and concerns about
affordability. Research suggests that between 50 and 75 percent of the
growth in health expenditures in the United States is attributable to
technological progress in health care goods and services. A strong
reliance on market mechanisms will ensure that incentives for innovation
are maintained while providing high-quality care in the most
cost-efficient manner.

Health insurance plays a central role in the workings of the
U.S. health care market. An understanding of the strengths and weaknesses
of health insurance as a payment mechanism for health care is essential to
the design of reforms that retain incentives for innovation while reining
in unnecessary expenditures. Over-reliance on health insurance as a
payment mechanism leads to an inefficient use of resources in providing
and utilizing health care. Reforms should provide consumers and health
care providers with more flexibility, more choices, more information, and
more control over their health care decisions.

Chapter 11, The Tort System, discusses the role of the U.S. tort
system
and the considerable burden it imposes on the U.S. economy. The tort
system is intended to compensate accident victims and to deter potential
defendants from putting others at risk. Empirical evidence, however, is
mixed on whether the tort system effectively deters negligent behavior.
Moreover, the tort system is a costly method of providing insurance
against a limited number of injuries. Research suggests that tort
liability also leads to lower spending on research and development, higher
health care costs, and job losses.

Ways to reduce the burden of the tort system include limits on noneconomic
damages, class action reforms, trust funds for payments to victims such as
in asbestos, and allowing parties to avoid the tort system contractually.
The Administration has proposed a number of reforms to reduce the burden
of the tort system while ensuring that people with legitimate claims can
recover damages.

INTERNATIONAL TRADE AND FINANCE

Chapter 12, International Trade and Cooperation, discusses how
growing
trade helps to spur U.S. and global growth. Since the end of the Second
World War, international trade has grown steadily relative to overall
economic activity. Over time, countries that have been more open to
international flows of goods, services, and capital have grown faster than
countries that were less open to the global economy. The United States has
been a driving force in constructing an open global trading system. The
Administration has pursued, and will continue to pursue, an ambitious
agenda of trade liberalization through negotiations at the global,
regional, and bilateral levels.

New types of trade deliver new benefits to consumers and firms in open
economies. Growing international demand for goods such as movies,
pharmaceuticals, and recordings offers new opportunities for U.S.
exporters. A burgeoning trade in services provides an important outlet
for U.S. expertise in sectors such as banking, engineering, and higher
education. The ability to buy less expensive goods and services from new
producers has made household budgets go further, while the ability of
firms to distribute their production around the world has cut costs and
thus prices to consumers. The benefits from new forms of trade, such as in
services, are no different from the benefits from traditional trade in
goods. Outsourcing of professional services is a prominent example of a
new type of trade. The gains from trade that take place over the Internet
or telephone lines are no different than the gains from trade in physical
goods transported by ship or plane. When a good or service is produced at
lower cost in another country, it makes sense to import it rather than to
produce it domestically. This allows the United States to devote its
resources to more productive purposes.

Although openness to trade provides substantial benefits to nations as a
whole, foreign competition can require adjustment on the part of some
individuals, businesses, and industries. To help workers adversely
affected by trade develop the skills needed for new jobs, the
Administration has worked hard to build upon and develop programs to
assist workers and communities that are negatively affected by trade.

The Administration has also worked to strengthen and extend the
global
trading system. International cooperation is essential to realizing the
potential gains from trade. Trade agreements have reduced barriers to
international commerce, and contributed to the gains from trade. A system
through which countries can resolve disputes can play an important role in
realizing these gains.

Chapter 13, International Capital Flows, discusses the economic
benefits
and risks associated with the transfer of financial assets, such as cash,
stocks, and bonds, across international borders. Capital flows have
become an increasingly significant part of the world economy over the past
decade, and an important source of funds to support investment in the
United States. Around $2 trillion of capital flowed into all countries in
the world in 2002, with around $700 billion flowing into just the United
States. Different types of capital flows.such as foreign direct
investment, portfolio investment, and bank lending.are driven by different
investor motivations and country characteristics. Countries that permit
free capital flows must choose between the stability provided by fixed
exchange rates and the flexibility afforded by an independent monetary
policy.

Capital flows can have a number of benefits for economies around the
world. For example, foreign direct investment can facilitate the transfer
of technology, allow for the development of markets and products, and
improve a country.s infrastructure. Portfolio flows can reduce the cost
of capital, improve competitiveness, and increase investment
opportunities. Bank flows can strengthen domestic financial institutions,
improve financial intermediation, and reduce vulnerability to crises.

A series of financial crises in emerging market economies, however, has
raised some concerns that financial liberalization can also involve risks.
In countries with weak institutions, poorly regulated banking systems, or
high levels of corruption, capital inflows may not be channeled to their
most productive uses. One approach to limiting the risks from capital
flows when legal and financial institutions are poorly developed is to
restrict foreign capital inflows. Experience suggests, however, that
capital controls impose substantial, and often unexpected, costs.
Instead, countries are more likely to benefit from free capital flows and
minimize any related risks, if they adopt prudent fiscal and monetary
policies, strengthen financial and corporate institutions, and develop
sound regulations and supervisory agencies. The Administration has
promoted policies to help countries reap the benefits from the free flow
of international capital.

Chapter 14, The Link Between Trade and Capital Flows, shows that
trade
flows and capital flows are inherently intertwined. Changes in a
country.s net international trade in goods and services, captured by the
current account, must be reflected in equal and opposite changes in its
net capital flows with the rest of the world. The large net inflow of
foreign capital experienced by the United States in recent years has
funded more investment than could be supported by U.S. national saving.
Corresponding to these inflows is the large U.S. current account deficit.
These patterns reflect fundamental economic forces, notably strong growth
in the United States that has made investment in this country attractive
compared to opportunities in other countries.

An adjustment of the U.S. current account deficit could come about in
several ways. Faster growth in other countries relative to the United
States could increase demand for U.S. net exports. Trade flows could also
adjust through changes in the relative prices of U.S. goods and services
compared to the prices of foreign goods and services. Any reduction in
the U.S. current account deficit would also require reduced net capital
inflows into the United States. This might occur if U.S. national saving
increased, reducing the need for foreign funds to finance U.S. domestic
investment, or if U.S. investment declined, so that the United States
required less capital inflows. Lower investment is the least desirable
form of balance of payments adjustment, however, as it could slow the
expansion of U.S. productive capacity and reduce economic growth.

It is impossible to predict the exact timing or magnitude of any
adjustment in the U.S. current account balance. After a large increase in
the U.S. current account deficit in the 1980s, the ensuing adjustments
were gradual and benign. Public policies can facilitate smooth changes in
the U.S. current account and net capital flows by creating a stable
macroeconomic and financial environment, promoting growth abroad, and
encouraging greater saving in the United States.

CONCLUSION

The future of the U.S. economy is bright. This is a testament to the
institutions and policies that have unleashed the creativity of the
American people and their spirit of entrepreneurship. History teaches
that the forces of free markets are the bedrock of economic prosperity.

In 1776, as the Founding Fathers signed the Declaration of Independence,
the great economist Adam Smith wrote: "Little else is requisite to carry a
state to the highest degree of opulence from the lowest barbarism but
peace, easy taxes, and a tolerable administration of justice: all the rest
being brought about by the natural course of things." The economic
analysis presented in this Report builds on the ideas of Smith and
his
intellectual descendants by discussing the role of the government in
creating an environment that promotes and sustains